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Monday, January 27, 2014

How Deep Will the Correction Be in US Equities?

Friday saw the first 2% down day since Nixon resigned... or that's what it seems like anyway. We've all become conditioned to the Invisible Hand supporting the market at all times recently, so the relentlessness of Friday's sell-off wasn't something any of us are "used to" anymore. By the same token, as I've written about in almost every article this month, there have been repeated warning signals in the charts -- so while Friday's decline definitely exceeded near-term expectations, it certainly didn't come as a surprise.

So where are we now? Bull markets, particularly near the tail end of third wave rallies, tend to breed an unusually high level of complacency (as I wrote about last week; See: Bulls Are Happy Now, But Charts Suggest Caution), so there are probably now a lot of trapped bulls north of SPX 1810. That zone could represent solid resistance to any rallies.

A near-term bounce isn't out of the question, since the market is oversold on a number of near-term metrics. The key to remember with this, I think, is that to say this market is anywhere close to being oversold at an intermediate level is ridiculous. Everyone and their mother's dog is still net long this market, so a continued shake up is entirely possible, and probably needed.

Let's lead off the charts with the S&P 500 Spyder ETF (SPY). Back in November, I outlined my "out on a limb" extended fifth wave preferred count in this index, and suggested that an extended fifth would travel up to 184-186, then reverse back to 175-177. We can see on the chart that the all-time-high was dead in the middle of the anticipated target/reversal zone -- and Friday's decline made good progress toward the first downside target. Whatever happens from here, we're way ahead of the game already.

I've outlined my "perfect world" path on the chart, assuming this count continues tracking. An alternate count is noted, and the two charts which follow SPY give more detail on some of the signals to watch heading forward.

Next is the S&P 500 (SPX) long-term chart, which has tracked almost as well (SPX exceeded my target zone by about 10 points before turning). The main notable feature of this chart is the breakdown of the bearish rising wedge (a pattern we've been watching for the past few months). Rising wedges typically return to roughly where they began -- and they usually do so in 1/2 to 2/3 the amount of time they took to form. This wedge pattern falls under "classic" technical analysis -- so it's interesting to note that its expectations also fit the "rapid retrace" expectations of Elliott Wave Theory for an extended fifth wave.

Incidentally, to say Wednesday's bearish sell trigger (not shown on this chart) was a success is a bit of an understatement. Also worthy of some mention: On Friday I noted that there was a remaining bull potential, in the form of an expanded flat, which targeted 1795 +/-. The market exceeded that target slightly, but that option currently still remains viable, if lower probability. The first step for bulls would be to form a small impulsive rally wave off the low -- so we'll cover that option in more detail if it becomes more relevant to do so.

For now, we're going to stick with November's preferred count of an extended fifth, with the expected retrace now underway. Since the results have continued to match the expectations, the market has given us every reason to continue favoring that original thesis.

Finally, the recent top in SPX is a bit noisy on the chart -- so for the moment, I suggest we use another market as our "canary in the coalmine." Below is the NYSE Composite (NYA), a much broader market than SPX. This chart has the advantage of providing a clear pivot level on the upside. I've saved some of the caveats for this chart, so please read the blue annotations for additional thoughts.

In conclusion, while the market has not yet formed a five wave impulsive decline, it has given us reason to continue favoring the preferred count of the past several months. A fourth wave rally and fifth wave decline this week would create a larger five-wave (impulsive) decline, and go a long way toward adding confidence to that intermediate view. Trade safe.

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